Berkshire's Derivative Losses Don't Matter

On Friday, Berkshire Hathaway (NYS: BRK.A) (NYS: BRK.B) released its third-quarter earnings results. The big highlight: Operating earnings are up 36.8% mostly because of stronger insurance underwriting and excellent results from MidAmerican and Burlington Northern Santa Fe. As a Berkshire shareholder, I say woo-hoo!

But there was trouble in paradise. Since the Dow (INDEX: ^DJI) and other global markets contracted during the third quarter, the value of the put options Berkshire is short went up. Thanks to mark-to-market accounting, this led to an overall decrease in profits of 23.8% for the quarter versus this time last year.

Some finance journalists are using this to tease Buffett, especially considering he labeled derivatives "financial weapons of mass destruction" back in 2002. While this criticism sounds very clever to the untrained ear, it's important to realize that Buffett's derivative bets are nothing like the AIG (NYS: AIG) type he was clearly scolding in 2002.

Berkshire's derivative bets are simply a bet that global markets will be higher in 2019. That's basically it. You, dear Fool, make the same bet when you commit to investing for the long term regardless of market fluctuations (haven't you?).

The truth of the matter is that Berkshire's derivative losses are no more real in the long term than unrealized losses on an S&P 500 index fund, like the popular SDPR (NYS: SPY) . In some quarters Berkshire's derivatives will help Berkshire's results, and in others they will hurt them. All that really matters though is where they stand in 2019 or thereabouts. If markets are higher in 2019, Berkshire wins. If they are lower than they were written at 2008 or thereabouts, Berkshire loses.

I'd say it's a pretty good bet markets will be higher in 2019 than in 2007, wouldn't you?

Now, you may be wondering, why did Buffett use derivatives to make the bet (and open himself to criticism) instead of simply investing in the S&P 500 index fund, a FTSE 100 index fund, or the publicly traded SPDR DJEuro Stoxx 50 (NYS: FEZ) , and MAXIS Nikkei 225 (NYS: NKY) . Why write puts on those indexes rather than just invest in them?

The answer is that when you write (short) a put option on an index, you receive cash you can reinvest elsewhere, like Lubrizol (assuming you don't need to hold it as collateral). When you invest in an index fund or ETF, you spend cash that you can't invest elsewhere. By writing puts and reinvesting the proceeds, Buffett is basically making a leveraged bet on world markets. Considering the company's $35 billion cash coffers, this isn't nearly as risky as it looks.

The bottom line is that if you agree with Berkshire's investing acumen, the derivative performance isn't a reason to question it. It affirms it.